The Dreamcast looked like nothing else out there. A lighter box than the uniform black or grey, four joypad ports, a bizarre controller with a memory card that had its own screen and worked as a separate miniature games console. The name – a portmanteau of Dream and Broadcast – was strangely ethereal for a games console (Sega had apparently gone through 5,000 possibile monikers to get here). When a prototype was shown to the press in the summer of 1998, there was no Sega logo. This was a new dawn. This was the future.

Sega was the perennial underdog in the video game console market. When it launched its first consoles – the SG-1000 and Master System – in the early 1980s, it was dealing with a competitor that ruled 96% of the market via its ubiquitous Nintendo Entertainment System. Back then, people didn’t say they were playing on a console. They said: “I’m playing Nintendo.” The brand was utterly dominant.

Then came the Sega Mega Drive (or Genesis in the US), a mighty 16-bit machine, with sleek arcade conversions and a new hero in the spiky form of Sonic the Hedgehog. 45m sales later, Sega shared half the market with its old foe. The 32-bit Sega Saturn followed in 1994 but by now there was a new competitor: Sony. The PlayStation was supremely powerful, expertly marketed and designed for the new era of 3D polygonal visuals. It destroyed everything in its path.

The Tokyo Game Show, 2001, shows the Dreamcast among its rivals. The odds did not look good Photograph: Katsumi Kasahara/AP

But Sega had a vision. When work began on a successor to the Saturn, the company’s manufacturing divisions began to rethink what a games console should be. This was the mid-1990s, the dawn of the world wide web as a mass phenomenon, the era of Netscape Navigator, America Online and emerging web-hosting services such as Angelfire and Geocities; the internet was becoming a place to meet, communicate and play. At the same time, the PC was coming into its own as a platform for gaming, thanks to the arrival of specialist 3D accelerator cards, which boosted the graphics performance of the incoming Pentium-series machines. And somewhere amid all this, Apple was preparing to unleash its iMac vision on the world.

Dreamcast embodied all of this epochal action. Inspired by the PC market, the machine was built from “off-the-shelf” components, rather than proprietary chipsets, to drive down costs. At its heart the Hitachi SH4 processor, married with a graphics chipset provided by PowerVR (one of the big names in the PC hardware acceleration market), promised unparalleled visual performance; a deal with Microsoft saw the machine adopting the familiar Windows CE operating system, which would vastly increase the number of developers who could conceivably work with the hardware. Dreamcast was also the first major console to come with a built-in modem as standard, and Sega (which had already innovated with online games services on the Mega Drive) set about creating an online infrastructure to provide owners with multiplayer gaming, webTV, email and web browsing. It was something entirely new – a fully connected entertainment machine.

The Japanese launch in November 1998 was a stumbling, halting introduction, thanks to trouble manufacturing the PowerVR chips. But customers queued in their hundreds outside the big game stores in Tokyo, keen to see this odd new console and its killer app, Virtua Fighter 3tb, a new version of the biggest fighting game in Japanese arcades, boasting detailed models of favourite characters, 13 beautiful arenas, and sleek 60fps animation. It was an enticing hint of what was to come from this graceful 128-bit machine.

Shenmue introduced many new gameplay conventions, such as Quick-Time Events and forklift truck racing for capsule toys. Photograph: Sega

The Dreamcast, in its first two years, saw a burst of creativity and gameplay innovation that has perhaps never been surpassed. Sega’s talented internal development teams were utterly inspired. Games such as the urban skating adventure Jet Set Radio, the fast-paced puzzler Chu-Chu Rocket, the massively multiplayer role-playing adventure Phantasy Star Online and the open-world masterpiece Shenmue introduced whole new forms and conventions of interactive entertainment. There were astonishing arcade conversions in the shape of Crazy Taxi and Soul Calibur; there were oddities including the subaquatic life sim, Seaman, and the zombie-infested keyboard tutorial, Typing of the Dead.

The rules of game design were being rewritten; true visionaries such as Yu Suzuki (Shenmue, Ferrari 355), Tetsuya Mizuguchi (Rez, Space Channel Five) and Rieko Kodama (Phantasy Star, Skies of Arcadia) were in their pomp. Established genres were being mashed together to create hybrid beasts not divided into regulated stages or levels but set in vast, open environments: Sonic Adventure, Metropolis Street Racer, and of course, Shenmue, a game that required players to effectively live in a mid-1980s rendition of Yokosuka.

The Dreamcast hinted at a new era of games: connected, open, complex and reactive to player curiosity. By building in a modem from the start, rather than requiring consumers to buy them separately, it made online features an intractable part of the console games industry, two years before Microsoft’s Xbox took that concept and really ran with it.

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But it was too early and it had too much baggage. Outside of Japan, major publishers hadn’t forgotten how the Saturn bombed against the PlayStation, and when Electronic Arts decided not to support Dreamcast, other companies followed suit. The original dialup modem was too slow for the coming era of multiplayer shooters (though it ran a wicked version of Quake III Arena), and the attendant online services too complicated and unwieldy.

And on the horizon, just out of reach but utterly tantalising, was the PlayStation 2. Sony was preparing something special, a much more powerful machine with a hyperbolically named Emotion Engine processor, backwards compatibility for PlayStation titles and the capability to play DVDs. Dreamcast enjoyed a decent US launch in 1999, with 500,000 units shifting in the opening weeks, but this was a blip on its downward trajectory. When Sony premiered the PS2 at the Tokyo Game Show in September with Tekken Tag Tournament and Gran Turismo 2000, the game was up.

The Dreamcast was the future in so many ways, but, like many technological groundbreakers throughout history, it had the right ideas at the wrong time. Its great highs live on, however – in the careers of Sega’s great designers, in the legacy of Shenmue, in the memories of players who first discovered the thrills of taxi simulations, graffiti sims and maraca-shaking rhythm action games. But by 2001, the dream was effectively over.

There was nothing else out there quite like the Dreamcast. In many ways, there still isn’t.